Action Now = Tax Savings in April

The point of this year-end maneuver is to lock in a tax loss by selling bonds that have fallen in value (usually because market interest rates have risen) and reinvesting the proceeds in other bonds. Done right, you can maintain the income stream from your bonds. Consider this example: Assume you own $100,000 worth of AA-rated bonds with a 6% coupon and a maturity date in 2016. In November, as you begin your year-end planning, the market price of your bonds has slipped to $84,750. If you sell at that price, you’ll have a $15,250 loss. At the same time, assume you can buy $100,000 face value of AAA-rated bonds, with a 7% coupon and a 2015 maturity, for $83,612.
If you sell one set of bonds and buy the other, look what happens: Since they have the same par value and coupon rate, your annual income remains the same: $7,000. Your bond rating increases from AA to AAA. You pull $1,138 out of the investment — the difference between what you got for the old bonds and what you paid for the new ones. And you can claim a $15,250 tax loss. If it offsets gains that otherwise would have been taxed at 20%, you save $3,050.

As with much year-end tax planning, the earlier you begin scouting for promising candidates for swapping, the better. The supply dwindles and competition from other investors heats up as the year draws to an end.

6. Don’t Buy a Tax Bill

Mutual funds often pay out most of their capital gains and dividends in December — and despite the market’s dismal performance this year, many funds will still be making payouts this year. Don’t think you’re getting a windfall if you buy just before the payout. It’s a tax mistake. When interest, dividends and profits are paid out, share values fall by the same amount. But the payout is taxable; you’re better off buying after the distribution — you get your shares at the lower price and avoid the tax bill on what is essentially a rebate of part of your purchase price. Before you invest, call the fund to ask for the ex-dividend date — and buy after that day.

If you plan to sell shares around year-end, it usually makes sense to do so before the ex-dividend date. When you sell, any accumulated dividends and capital gains are included in the share price and therefore are considered part of your profit. If you’ve owned the shares more than 12 months, you get 15% long-term capital-gains treatment. When the fund pays out the dividends, the share price drops… and so does your taxable profit when you sell. But the 15% gains are replaced dollar for dollar by the income distribution — part of which could be taxed in your top bracket, as high as 35%.

7. Contribute the Maximum to Retirement Accounts

There may be no better investment than tax-deferred retirement accounts. They can grow to a substantial sum because they compound over time free of taxes. Company-sponsored 401(k) plans may be the best deal because employers often match contributions.

Bump up your 401(k) contribution so that you are putting in the maximum amount of money allowed ($15,500 for 2008). If you think you can’t afford it, run the numbers. If you have a traditional 401(k), the fact that pre-tax money goes into your account means your savings go up more than your take-home pay goes down. If you’re in the 25% federal tax bracket, for example, stashing an extra $1,000 in your 401(k) cuts take-home pay by just $750, and even less if you live in a state with a state income tax. If your firm offers the new Roth 401(k) option, an extra $1,000 into the account really costs you $1,000 now, because after-tax money goes into a Roth 401(k). But the fact that withdrawals in retirement will be tax free could make this the better home for your increased contributions.

If you are 50 or older by the end of the year, you are eligible to make “catch up” contributions to your 401(k) plan, if your employer’s plan allows this provision. If you qualify for the “catch up,” you can contribute an extra $5,000 to your 401(k) plan in 2008, for a total of $20,500.

If you’re lucky enough to get a year-end bonus, you can steer part of it to your 401(k), if you haven’t already maxed out.

Also consider contributing to an IRA for yourself and your spouse. You have until April 15, 2009, to make IRA contributions for 2008, but the sooner you get your money into the tax-shelter, the sooner it earns tax-deferred (in a traditional IRA) or tax-free (in a Roth version) returns. The basic contribution for IRAs (either traditional or Roth or a combination of the two) for 2008 is $5,000, but those 50 and older by year end can contribute an extra $1,000 for a total of $6,000.

Self-employed people should set up Keogh plans by December 31. Once the plan is in place, you can contribute up to $46,000 until the tax filing deadline (including extensions) for your 2008 return. Every dime you contribute can be deducted on your return to cut your tax bill for 2008.